Late Cycle Bond Trades | Mark Cabana on Mild Recession Case and Treasury Market Supply

Episode Summary

Executive Summary: Mark Cabana argues the bond market is in an unusually inverted, high-rate regime that reshapes funding incentives and bank behavior, but recent banking stress has eased as institutions adapted and official backstops stabilized liquidity. He sees Treasury yields drifting lower mainly because the Fed will likely cut in 2024 amid a mild slowdown, even as supply-demand imbalances may cheapen Treasuries versus swaps. QT can continue until recession or reserve scarcity, and SEC money fund reform helps liquidity but won’t fully prevent future dash-for-cash events.

Main Topics: Unusual bond market regime: high rates and deep inversion (Priority: 5/5): Cabana says today’s fixed-income backdrop is unlike recent history: rates are near two-decade highs and the curve is more inverted than it has been in decades, which changes investing and funding behavior. Banking stress, funding markets, and post-SVB stabilization (Priority: 5/5): He explains why March bank failures raised financial-stability fears, how banks responded by tapping expensive funding, and why concern has since eased as precautionary borrowing was paid back and emergency usage slowed. Federal Reserve response and BTFP effectiveness (Priority: 5/5): Cabana viewed the Fed/Treasury/FDIC response as necessary to stop contagion; the Bank Term Funding Program reduced fire-sale risk by letting banks borrow against high-quality securities at par and favorable terms. Treasury demand, supply-demand imbalances, and curve cheapening risk (Priority: 4/5): He outlines which buyers are strongest or weakest for Treasuries and warns that dealer balance-sheet constraints and leverage costs could create back-end cheapening versus OIS/swaps even if the policy rate path falls. Fed cuts outlook and timing (Priority: 5/5): BofA expects a mild recession or growth recession in early 2024, leading to rate cuts starting around May 2024; Cabana says the market is pricing too many cuts too soon. Quantitative tightening and balance-sheet runoff (Priority: 4/5): QT can persist as long as the Fed avoids recession, severe market dysfunction, and reserve scarcity; Cabana expects QT to stop around May in the base case, but possibly not until late 2025 absent a downturn. Money market fund reform and remaining market fragility (Priority: 4/5): He says SEC rule changes reduce first-mover advantage in prime funds but do not solve the core 2020 market-stress problem: dealer-intermediation breakdown during a dash for cash.

Key Arguments: An inverted curve makes funding costs exceed bond yields, creating negative carry and discouraging traditional borrow-short/lend-long strategies. Recent stabilization in bank funding markets is visible in reduced Federal Home Loan Bank borrowing, slower emergency Fed lending, and less frantic money-fund inflows. The BTFP was effective because it allowed banks to fund high-quality securities at par and below-market rates, reducing the need for forced sales. Treasury demand is not evenly distributed: foreign demand is weak, pensions/insurers are price-insensitive, asset managers are already long, and levered hedge funds depend on repo and balance-sheet capacity. Even if Treasury cheapening occurs versus swaps, longer-term yields can still fall if the expected Fed path declines as the economy slows. Cabana expects the Fed to cut because inflation is moderating and growth/hiring are slowing; the timing is likely around May 2024 in a mild-recession base case. The market may be overpricing the speed and magnitude of cuts; Cabana recommends fading aggressive front-end easing expectations. QT will end when the Fed faces recession, market-functioning problems, or reserve scarcity; in the base case, recession cuts would likely end QT first. SEC money fund reforms are useful for reducing first-mover incentives but do not fix the underlying dealer-balance-sheet problem that drove the 2020 liquidity freeze.

Data Points: Current rate levels: Highest in almost two decades - Cabana on today’s U.S. bond market rate level Yield curve shape: Most inverted in decades - Cabana describing the current curve Bank survey concern share: 38% - April 2023 BofA Global Research investor survey citing financial stability/fragile markets as the top concern Bank survey concern share: 11% - July survey share for financial stability concern FHLB debt increase: About $300 billion - Increase in Federal Home Loan Bank debt outstanding from early March to end-May FHLB debt increase as share: Roughly 20% - Approximate rise in total FHLB debt outstanding FHLB paydown: About $250 billion - Amount of the $300 billion increase paid back since end-May FHLB paydown rate: Over 80% - Portion of the temporary FHLB borrowing that was paid down Fed neutral estimate: 2.5% - Fed’s estimate of neutral nominal policy rate BofA long-run 10-year forecast: 3.25% - Cabana’s long-run 10-year Treasury forecast including term premium and structural inflation/real-rate assumptions Implied inflation assumption: 2% - Cabana’s assumption for average inflation over time Real rate assumption: 50 bps - Fed-neutral real rate component Cabana referenced Additional buffer added by Cabana: 25 bps each on inflation and real rates - His adjustment to get to a higher neutral estimate QT stop timing, base case: May 2024 - Cabana’s base-case view if recession and rate cuts arrive as expected Reserve scarcity timing if no stop: Deep into 2025 or early 2026 - Potential time when the Fed might hit reserve scarcity absent recession/market stress Balance sheet reduction timing in model: Second half of 2025, probably September-ish - Based on Fed/New York Fed-style balance sheet modeling Fed cut timing: May of next year - Cabana’s expected start of Fed easing Typical cut pace in 2019 analogy: 25 bps per meeting - Cabana comparing expected easing path to 2019 Target endpoint for cuts: 2.5% - Cabana notes the Fed’s notion of neutral as the likely endpoint for cuts Money fund rule implementation timing: Second half of 2024 - When SEC money market fund rule changes are expected to take effect

Pivotal Quotes: "We're at really the highest rate levels that we have seen in almost two decades. And two, the shape of the curve. We're at the most inverted that we have been in decades." — Mark Cabana: On what stands out in today’s bond market "The bank term funding program was a very effective tool for the Fed to deploy." — Mark Cabana: Assessing the official-sector response to the March bank failures "We just think that the duration play is clearer and easier at the end of the cycle as opposed to the curve trade." — Mark Cabana: Why BofA prefers owning the 10-year versus a steepener expression

Implications: Listeners should expect a slower-growth, lower-yield environment, but with continued volatility in Treasuries from supply-demand and funding pressures. Banks and investors still need to watch repo, dealer balance sheets, and the Fed’s cut timing closely.